Wednesday, August 29, 2012

In [Donald] Yacktman's view, businesses with both low capital intensity and low cyclicality (Coke: KO, Pepsi: PEP, and P&G: PG are the specifics mentioned) are likely to earn the highest returns.The benefits owning shares in quality businesses long-term (especially if bought when occasionally selling at a fair or better than fair price) comes down to potential returns relative to risk.Simple to understand? Certainly. Easy to implement as a core investing approach? A bit less so.
The evidence to support the merits of owning shares in these kinds of businesses long-term isn't hard to find nor is it particularly complicated. A simple insight can sometimes trump details and complexity. When it occasionally does, use it. What's simple can beat the complex and, in fact, often does.Yet simple isn't always better. It is just that what is used should be neither more simple nor more complicated than it need be.It's possible, of course, to make things too simple.Science views complexity as a cost. That additional complexity must be justified by the benefits. "In science complexity is considered a cost, which must be justified by a sufficiently rich set of new and (preferably) interesting predictions..." - From the book "Thinking, Fast and Slow" by Daniel Kahneman

Well, investors ought to view complexity in a similar way. Investing is always about getting the best possible returns, at the lowest possible risk, within one's own limits. Since it is already inherently enough of a challenge, there's no need to make it more so by adding unnecessary complexity. Don't use calculus when arithmetic will do the job. Save the more powerful tools for when they can actually add value (and especially avoid some of the worse-than-useless overly complex theories taught by modern finance).Now, just because something is relatively simple doesn't mean lots of homework isn't necessary.

There absolutely is lots of hard work involved.
The reason for and advantage of owning shares in some of the quality franchises -- superior returns at less risk if bought well -- is clearly not all that difficult to understand. Having enough discipline, patience, and the right temperament to stick with it is the tougher part. Well, that and maybe not becoming distracted by the various forms of investing alchemy cloaked in incomprehensible faux sophistication: "...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." - Warren Buffett in the 1987 Berkshire Hathaway Shareholder LetterQuality stocks. Less drama. Little mystery. Effective. Think of them as the "two aspirins" of investing. I'm sure that many will still choose to own shares of the highest quality stocks primarily for "defensive" purposes. I doubt that changes anytime soon. Somehow, the thinking goes, they'll jump in and out while not having mistakes and frictional costs to subtract from total return. Sounds good in theory. I'm sure there are even some who can make that sort of thing work for them. There are likely even more who incorrectly think they can.

So, despite the evidence, investing in high quality businesses long-term remains an approach that's still not frequently employed.*(I mentioned in the previous post that Jeremy Grantham has described these high quality businesses as the "one free lunch" in investing.)

It's a subject I've covered many times on this blog (okay...maybe too many times based upon the number of related posts I have listed below) because it just happens to have been and remains a cornerstone of investing for me.

Unfortunately, investors need more patience now compared to when valuations were quite attractive not too long ago (though at least it's not nearly as bad valuation-wise as it was a decade or so ago). Most of the best quality enterprises are rather fully valued right now.
(Over the shorter run -- less than five years -- anything can happen as far as relative performance goes. It's the longer time horizons -- more like twenty years or so -- that the "offensive" merits of high quality businesses become more obvious. A full business cycle or two. I realize that some, or maybe even many, market participants consider five years to be longer term these days.)Still, it makes sense to embrace any simple, understandable, yet effective method of delivering above average risk-adjusted returns while generally avoiding the esoteric.**Finally, the assessment of risk is necessarily imprecise and is certainly not measured by something like beta. Real risks does not lend itself to the all too popular quantitative methods. What can be measured, should be, but much of the important stuff can't be measured all that well. It requires a mixture of both quantitative and qualitative.

"You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger in this speech at UC Santa BarbaraWhen it comes to managing risk (and many other things), it's often a mistake to allow the less important but easy to measure stuff to triumph over what's more meaningful if tougher to measure.

AdamLong positions in KO, PEP, and PG established at much lower than recent market prices. No intention to buy or sell shares near current valuations.Related posts:The Quality Enterprise, Part II - Aug 2012The Quality Enterprise - Aug 2012Consumer Staples: Long-term Performance, Part II - Dec 2011Consumer Staples: Long-term Performance - Dec 2011Grantham: What to Buy? - Aug 2011Defensive Stocks Revisited - Mar 2011KO and JNJ: Defensive Stocks? - Jan 2011Altria Outperforms...Again - Oct 2010Grantham on Quality Stocks Revisited - Jul 2010Friends & Romans - May 2010Grantham on Quality Stocks - Nov 2009Best Performing Mutual Funds - 20 Years - May 2009Staples vs Cyclicals - Apr 2009Best and Worst Performing DJIA Stock - Apr 2009Defensive Stocks? - Apr 2009* To me, the shares of many of these businesses are not especially cheap these days even if they have been at times over the past few years. It's worth waiting for a good price then acting decisively when valuation is attractive. Since each is unique, the necessary homework to build some depth of knowledge and understanding can be done while waiting for the right price. These may be lower risk but they're certainly not no risk. Margin of safety still matters. There's no way around the preparation and patience required in investing. After figuring out what's attractive at a certain price lots of waiting is inevitably necessary.** Some may become bored by the straightforwardness. A few may even choose more complicated, high risk journeys just to enhance the challenge. Long-term Capital Management (LTCM)comes to mind. Charlie Munger said it best in this 1998 speech:"...the hedge fund known as 'Long-Term Capital Management' recently collapsed, through overconfidence in its highly leveraged methods, despite IQ's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger's 1998 speech to the Foundation Financial Officers GroupUncomplicated, understandable, yet effective ways to produce attractive risk-adjusted returns should be embraced. Sophisticated or esoteric methods, especially those involving leverage, should not. Best to be wary of overconfidence in any profession. It can get even the most talented into trouble.Munger's Speech to Foundation Financial Officers - 1998
---This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Origin of Newton's 4th Law?

"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." - Warren Buffett

About The Site

This site is for generalized informational purposes only and the views found here should never be considered specific investment advice.

Visitors should always do their own homework and consult, as needed, with a personal financial adviser who understands their specific individual circumstances before taking action on any particular investing idea. What makes sense as an investment in one set of individual circumstances may not in another.

Opinions found on the blog are just that, opinions, could easily be wrong in all kinds of ways, and should never be considered advice that is specific in nature. Stocks and other investment vehicles are inherently filled with risks including the possibility, or even likelihood, of permanent loss of capital. Past performance, of course, should not be considered indicative of future results. Due diligence is necessary.

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All posts are simply presented as one view on investing and some related topics though never specific recommendations. An investor should always get help from an investment professional if they feel they need it and, most importantly, before mistakes are made. Ultimately, the actions of individual investors, whether they happen to be a visitor to this site or not, are their own responsibility (and, if applicable, so are the associated losses). While there will always be a very real risk of permanent capital loss in investing, those who know their own limits and ask for professional advice when they require it can improve their chances substantially. Investors should never buy or sell a security based upon what they've read on any blog.

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Posts on this blog do not offer opinions on the future price action of specific stocks or the capital markets as a whole. Instead, the focus is sound investing principles but never predictions or recommendations. It's understanding productive assets and their likely intrinsic value; how they may or may not compound in intrinsic worth over a long time horizon. It's about investing with a comfortable margin of safety. It's NOT about speculating on price action. In the near-term, or even longer, the market price of an asset can do just about anything.

A temperamental market pretty much assures it.

Those with a long investing horizon, it's worth noting, actually benefit from lower stock prices in the near-term (though not many market participants seem willing to put this truism to effective use). Those who attempt to profit primarily via speculating on short-term price action likely won't find this way of thinking to be of much interest.

The bottom line: This site does not provide individual investment advice of any kind and the blog posts found here are never a recommendation to buy or sell anything. Visitors should start with the assumption that the ideas found here are not good ones and do their own homework (or get individualized help from an investment professional) before taking ANY action.

This site's emphasis? Put simply, it's on finding and buying -- with the long-term in mind -- good businesses at a plain discount to conservatively estimated value; it's on selling shares of those well-bought high quality business reluctantly. The view here is that selling makes sense only when core economics become permanently impaired, prospects have been misjudged, market price not just somewhat but, instead, meaningfully exceed per share intrinsic value, or opportunity costs are high. Buy/sell decisions aren't just an opportunity to increase returns; they're also an opportunity to make mistakes. It's easy to overemphasize the former and forget the latter. The focus here is on minimizing trading, frictional costs, and errors of all kinds; it's on staying comfortably within realistically assessed limits. First and foremost is the view that an investor should never make a specific investment based upon what someone else thinks. In other words, what makes sense to own is necessarily unique for each investor and it'd be unwise to not act accordingly. So, more generally, this site simply attempts to better understand some useful principles and ideas in context of investment. It's about, in a practical sense, what tends to work over the long haul as well as what, at times, gets the investor into trouble. It's not about grand theories in finance and economics. These too often distract from what matters or, worse yet, lead to costly misjudgments. As a result, they are mostly viewed with a healthy dose of skepticism here. Otherwise, the best thinking across disciplines should be learned well then put to good use in a way that's uniquely suitable.

About

Notable Quote

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles... ...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?" - Charlie Munger